How to trade the Fed opening the door for a March rate cut

Forex

Steen Jakobsen

Chief Economist & CIO

Summary:  The fallout from the coronavirus will likely see the Fed downgrading its outlook for growth and waxing dovish on rates, which could see a sharp repricing of expectations for a Fed rate cut already in March. Such a move is far from priced in and could lead to very large moves in short term EuroDollar interest rate futures.


The coronavirus outbreak in China and the major disruptions it has caused will impact the growth outlook with the massive disruptions to travel and basic economic activity – think retail activity and simply the movement of people to and from work, etc.. - across vast swaths of China and as travel to and from China is vastly curtailed until the threat has peaked and ended, a process that could take a few months at best. The Powell Fed is not likely to miss the opportunity to raise concerns on the implications for US growth and especially the inflation outlook from this disruption and could open the door wide for a March rate cut. Eurodollar Futures traders are already pricing higher odds of a cut, but are far from pricing a March move.

Traders looking to trade a more dovish Fed can go long EuroDollar futures (3-month short-term interest rate – strictly speaking this tracks the Libor fixing, but that tracks US 3-month interest rates very closely), as the market has not yet priced in a full 25 basis point rate cut through the June meeting. If the Fed begins cutting again on concerns for the outlook, it could cut in both March and at least once more through the June meeting – actions that are not yet priced in the market. See more on the specific contract and levels below.

Trade: Long the June 2020 EuroDollar contract (GEM0) in 98.40 area, with a stop below 98.30 and a target of 98.75, trailing the stop by 20 ticks once the price exceeds 98.50.

Risk: The risk to this position is that the Fed fails to tilt as dovishly as we expect and sends the message that it  would prefer to wait and see for now on interest rates in coming months, leaving to a higher rate expectation from the Fed and leading to a stop-out of the position.

 

Chart: June 2020 EuroDollar STIR future

Note that this recent rally has broken the late trendline and that if the market is to price a full rate cut and possibly two, the contract could reach new highs as the market prices a 1-1.25% Fed policy rate on the other side of the June meeting (post-June meeting expectations currently at about 1.45% vs. 1.625% currently)

Chart: June 2020 EuroDollar STIR future. Source: Saxo Bank
Chart: Longer term chart of GEM0 – 2020 EuroDollar STIR future. Source: Saxo Bank

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